If the returns on your mutual fund are flat and dismal, you're not alone. With the S&P down 1.65% so far this year, everything's looking pretty drab. But if holding a stagnant fund wasn't bad enough, you might actually get hit with a distribution before year-end on which you'll owe tax in April. Many mutual funds will be making taxable distributions to shareholders this year, and some of them may be meaty. "We have seen some sizable estimates from companies," says Greg Carlson, a fund analyst at Morningstar. Of course, all things are subject to change between now and the time your fund actually pays that distribution at year's end, but fund companies are sending out warnings. Some shareholders will get a bigger chunk than others. Small-cap and value funds have had a great stretch over the last few years, and, of course, energy funds have had a recent run as well. "You're most likely to see capital gain distributions from those types of funds," says Carlson. So be on guard. While these distributions aren't going to make you broke, you do need to be aware that they're coming and try to plan accordingly.
Mutual funds are required by law to distribute at least 90% of their realized capital gains and dividend income to shareholders at the end of their fiscal year. That extra cash is taxable to you, whether you get a check in the mail or ask the fund to reinvest those distributions back into the fund. What's worse, funds must make these distributions even if their returns are in the toilet. So you can still owe tax on a fund that's on a losing streak. Here's why. Let's say your fund bought a stock back in 2002 for $15. The stock is up to $35 and the manager decided to sell it in 2005. The upside is that he made $20 a share. The downside is that gain is now "realized" and must be distributed to you, the shareholder, and will be taxed. The fund's overall performance, no matter how bad or how good, is irrelevant.